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With rising interest rates crushing the buy-to-let market, investors are looking elsewhere for a second source of income. And I think the stock market is a good place to look right now.
When investing through a stocks and shares ISA, I think investing £20,000 into an investment that can generate £4,116 a year (or £343 a month) is a sensible ambition. Here's how.
The maths
A compound annual return of 5% on £20,000 results in an investment that generates £4,116 per year after 30 years. I think this is realistic, given the historical performance of the investment. FTSE 100 Indexbut it's a long time to wait.
However, earning a higher average annual return could speed up the process. For example, earning a compound return of 6% per year results in a portfolio that generates £3,324 per year after 23 years.
With an average annual return of 8%, the time it takes to reach £343 a month is halved compared to 5%. With a compound interest rate of 8% per year, £20,000 becomes an investment that generates £4,351 a month after 14 years.
Nothing is guaranteed when it comes to investing, but it's worth noting that the difference between earning 5% and 8% can be quite significant when it comes to reaching £343 per month.
The strategy
With this in mind, I think it is important to aim for the best overall performance, and this means looking for the most attractive opportunities overall, rather than focusing on growth or dividends.
Obviously, the ultimate ambition is to earn a second income, but I don't think that means I have to focus exclusively on stocks of companies that pay out their profits in the form of dividends.
There are two reasons for this. One is that the best opportunities might not be in dividend-paying stocks, and the cost of settling for a lower return in terms of time to get to £343 a year could be quite high.
Another is that I don't need a company to distribute cash and earn a second income. If the companies I own shares in grow and retain profits, I can always sell part of my stake to get the increase.
An action to take into account
In some ways, having an unlimited universe of stocks to choose from makes it harder. But one that I think looks attractive right now is Diageo (LSE:DGE).
Over the past decade, revenue has grown by about 4% annually and earnings per share by 5%. And this has happened while the company has returned most of its free cash to investors in the form of dividends.
Growth is not without risks, however. The company has recently shown that it is not as recession-resistant as some investors might have imagined, as weak consumer spending has been weighing on demand.
However, this has been a problem for businesses in general and I think Diageo's scale gives it an advantage over smaller rivals that should put it in a good position in the long term.
Opportunistic investment
Whether it's growth or passive income, investing well means taking advantage of exceptional opportunities. That means buying shares of solid companies when prices are unusually low.
At this point, I think Diageo fits the bill. That's why I own the stock and plan to keep buying it as long as the price stays near its current levels.
